Fees and Mutual Fund Returns
4.8 Information on Mutual Funds
performers similarly would all remain in the bottom half. In fact, looking at the 1970s data in Panel A, the table shows that 65.1% of initial top-half performers fall in the top half of the sample in the following period, while 64.5% of initial bottom-half performers fall in the bottom half in the following period. This evidence is consistent with the notion that at least part of a fund’s performance is a function of skill as opposed to luck, so that relative performance tends to persist from one period to the next.8
On the other hand, this relationship does not seem stable across different sample periods. While initial-year performance predicts subsequent-year performance in the 1970s (Panel A), the pattern of persistence in performance virtually disappears in the 1980s (Panel B). To summarize, the evidence that performance is consistent from one period to the next is suggestive, but it is inconclusive.
Other studies suggest that there is little performance persistence among professional managers, and if anything, bad performance is more likely to persist than good perfor- mance.9 This makes some sense: It is easy to identify fund characteristics that will result in consistently poor investment performance, notably high expense ratios, and high turnover ratios with associated trading costs. It is far harder to identify the secrets of successful stock picking. (If it were easy, we would all be rich!) Thus the consistency we do observe in fund performance may be due in large part to the poor performers. This suggests that the real value of past performance data is to avoid truly poor funds, even if identifying the future top performers is still a daunting task.
8Another possibility is that performance consistency is due to variation in fee structure across funds. We return to this possibility in Chapter 11.
9See for example, Mark M. Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance 52 (1997), 57–82. Carhart’s study also addresses survivorship bias, the tendency for better-performing funds to stay in business and thus remain in the sample. We return to his study in Chapter 11.
Suppose you observe the investment performance of 400 portfolio managers and rank them by investment returns during the year. Twenty percent of all managers are truly skilled, and therefore always fall in the top half, but the others fall in the top half purely because of good luck. What fraction of this year’s top-half managers would you expect to be top-half performers next year?
Concept Check 4.4
The first place to find information on a mutual fund is in its prospectus. The Securities and Exchange Commission requires that the prospectus describe the fund’s investment objectives and policies in a concise “Statement of Investment Objectives” as well as in lengthy discus- sions of investment policies and risks. The fund’s investment adviser and its portfolio manager are also described. The prospectus also presents the costs associated with purchasing shares in the fund in a fee table. Sales charges such as front-end and back-end loads as well as annual operating expenses such as management fees and 12b-1 fees are detailed in the fee table.
Funds provide information about themselves in two other sources. The Statement of Additional Information (SAI), also known as Part B of the prospectus, includes a list of the securities in the portfolio at the end of the fiscal year, audited financial statements, a list of the directors and officers of the fund (as well as their personal investments in the fund),
and data on brokerage commissions paid by the fund. However, unlike the fund prospec- tus, investors do not receive the SAI unless they specifically request it; one industry joke is that SAI stands for “something always ignored.” The fund’s annual report also includes portfolio composition and financial statements, as well as a discussion of the factors that influenced fund performance over the last reporting period.
With thousands of funds to choose from, it can be difficult to find and select the fund that is best suited for a particular need. Several publications now offer “ency- clopedias” of mutual fund information to help in the search process. Morningstar’s Web site, www.morningstar.com, is an excellent source of information, as is Yahoo!’s site, finance.yahoo.com/funds. The Investment Company Institute (www.ici.org), the national association of mutual funds, closed-end funds, and unit investment trusts, publishes an annual Directory of Mutual Funds that includes information on fees as well as phone numbers to contact funds. To illustrate the range of information available about funds, we consider Morningstar’s report on Fidelity’s Magellan Fund, repro- duced in Figure 4.5.
The table on the left labeled “Performance” first shows the fund’s quarterly returns in the last few years, and just below that, returns over longer periods. You can com- pare returns to two benchmarks (the Russell 1000 and the S&P 500) in the rows labeled +/− Bmark, as well as its percentile rank within its comparison (or “Mstar category”) group (funds with a large growth stock orientation). The middle column provides data on fees and expenses, as well as several measures of the fund’s risk and return characteristics.
(We will discuss these measures in Part Two of the text.) The fund has provided good returns compared to risk in the last three years, earning it a 4-star rating, but its 10-year performance has been disappointing. Of course, we are all accustomed to the disclaimer that “past performance is not a reliable measure of future results,” and this is presumably true as well of Morningstar’s star ratings. Consistent with this disclaimer, past results have little predictive power for future performance, as we saw in Table 4.4.
More data on the performance of the fund are provided in the graph near the top of the figure. The line graph compares the growth of $10,000 invested in the fund versus its first benchmark over the last 10 years. Below the graph are boxes for each year that depict the relative performance of the fund for that year. The shaded area on the box shows the quar- tile in which the fund’s performance falls relative to other funds with the same objective.
If the shaded band is at the top of the box, the firm was a top quartile performer in that period, and so on. The table below the bar charts presents historical data on the year-by- year performance of the fund.
Below the table, the “Portfolio Analysis” table shows the asset allocation of the fund, and then Morningstar’s well-known style box. In this box, Morningstar evaluates style along two dimensions: One dimension is the size of the firms held in the portfolio as measured by the market value of outstanding equity; the other dimension is a value/growth measure. Morningstar defines value stocks as those with low ratios of market price per share to various measures of value. It puts stocks on a growth-value continuum based on the ratios of stock price to the firm’s earnings, book value, sales, cash flow, and dividends.
Value stocks are those with a low price relative to these measures of value. In contrast, growth stocks have high ratios, suggesting that investors in these firms must believe that the firm will experience rapid growth to justify the prices at which the stocks sell. In Figure 4.5, the shaded box shows that the Magellan Fund tends to hold larger firms (top row) and growth stocks (right column).
Finally, the tables in the right column provide information on the current composition of the portfolio. You can find the fund’s 20 “Top Holdings” there as well as the weight- ing of the portfolio across various sectors of the economy.
Data through April 30, 2016 FINRA members: For internal or institutional use only.
Benchmark 1: Russell 1000 Growth TR USD Benchmark 2: S&P 500 TR USD
Morningstar Analyst Rating 11-25-15
Neutral
Fidelity
®
Magellan®
Morningstar Pillars
Morningstar Analyst Rating
Analyst Rating Spectrum Pillar Spectrum
Performance 04-30-16
Morningstar's Take by Katie Rushkewicz Reichart, CFA 11-25-15
Portfolio Analysis 03-31-16 Gold Silver
Positive
2012 2013 20142015 2016
3 Mo 6 Mo 1 Yr3 Yr Avg 5 Yr Avg 10 Yr Avg 15 Yr Avg
Fidelity Magellan has started moving in the right direction during manager Jeff Feingold's four-year tenure, but for now it retains its Morningstar Analyst Rating of Neutral as it continues to show how its process fares in various market environments.
as high-quality name Qualcomm QCOM, weren't meeting his expectations after a few quarters of missed earnings, so he deployed the money into Maxim Integrated Products MXIM, which scored better on his quantitative framework. With the model constantly assessing the portfolio and other opportunities, the fund has had higher turnover than its typical peer during Feingold's tenure.
Despite more frequent trading, the fund has calmed down under Feingold. Its standard deviation of returns has fallen more in line with large-growth Morningstar Category peers. Its growth tilt has proven helpful versus its benchmark in recent years, but it's also posted decent results versus peers. The fund has yet to be tested in a down market under Feingold, though it did underperform peers and the benchmark in 2015's rocky third quarter.
The fund retains its Morningstar Analyst Rating of Neutral, though shareholders should be comforted by a smoother ride.
-0.170.03 -1.16 -2.500.50 -3.59 -1.47 16.39
9.13 2.042.84 -2.15
-5.21 2.84 4.581.12
—―
-0.88 10.54 5.168.30 —―
17.99 35.30 14.08 4.06 —―
7.90 9.05 -1.677.61 —―
Negative
12.44 12.97 1.04
0.6 1.02 96 -0.09
12.97 8.944.61 15.87
+AvgAvg Low
+AvgAvg High
Standard Deviation Mean Sharpe Ratio 1 Yr 3 Yr 5 Yr10 Yr Incept Neutral Bronze Neutral Negative Process
Performance People Parent Price
Neutral Neutral Positive Positive Positive
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 04-16 History
Ticker FMAGX Yield
0.6% Total Assets
$15,219 mil Mstar Category Large Growth
Investment Style Equity
Growth of $10,000 Investment Values of Fund Investment Values of Benchmark 1 20.0 15.0
10.0 Historical Profile
Return Risk Rating
Below Avg Above Avg Below Avg
Morningstar evaluates mutual funds based on five key pillars, which its analysts believe lead to funds that are more likely to outperform over the long term on a risk-adjusted basis.
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Total
Trailing
Along those lines, Feingold has paid close attention to selling when he thinks a stock is losing earnings momentum; that paved the way for a sale earlier this year of detractor Keurig Green Mountain GMCR. Others, such
©2016 Morningstar, Inc. All rights reserved. The information herein is not represented or warranted to be accurate, complete or timely. Past performance is no guarantee of future results. Access updated reports at www.morningstar.com. To order reprints, email [email protected]
Address: Fidelity Magellan Fund Minimum Purchase: $2500 Add: — IRA: $2500 Boston, MA 02109 Min Auto Inv Plan: — Add: — 800-544-6666 Sales Fees: No-load Web Address: www.fidelity.com Management Fee: 0.30%
Inception: 05-02-63 Actual Fees: Mgt:0.52% Dist:—
Advisor: Fidelity Management & Research Company Expense Projections: 3Yr:$224 5Yr:$390 10Yr:$871 Subadvisor: FMR Investment Management (U.K.) Limited Income Distribution: Semi-Annually
Feingold brings experience to the table, having previously served as an analyst, director of research, and manager of Fidelity Trend FTRNX. While this fund is benchmarked against the S&P 500 (versus the Russell 1000 Growth Index at Trend), it has a growth tilt, as Feingold looks for companies that can rapidly accelerate their earnings. To that end, he uses a proprietary, quantitative model to screen for opportunities and aid in portfolio construction, supplementing it with fundamental research from Fidelity's analyst team. He invests in a mix of high-growth names, steadier, high-quality fare, and firms that are cheap with improving prospects, striving to minimize big blowups and maintain fairly steady returns.
3 Yr (estimated) 5 Yr (estimated) 10 Yr (estimated)
6460 86 2.411.54 1.41 2260 93 10.24
7.25 3.13
10,575 9,846 9,991 14,416 15,341 15,699 17,141 Growth of
$10,000 29 18 2213 62 9180
%Rank -1.30 Cat -1.98 -1.29 -2.081.71 -2.29 -0.87 +/- Bmark 2 +/- Bmark
1 -1.545.75 -0.09 12.97 8.94 4.613.66 Total Return%
Tax Analysis Tax Adj Rtn% %Rank Cat Tax-Cost Rat %Rank Cat
Potential Capital Gain Exposure: 24% of assets
Current Investment Style Value Blend Growth Larg
eMidSmall
Value Measures
Growth Measures
Profitability Return on Equity Return on Assets Net Margin
20.02 7.45 14.69 Rel Category
42.12 1.84 6.20 13.37 20.71
0.98 0.33 12.65 1.05 0.86
Rel Category
Composition - Net
%
%
Mutual Funds Price/Earnings
Price/Book Price/Sale Price/Cash Flow Dividend Yield %
19.84 2.63 2.01 10.50 1.68
0.92 0.72 0.89 0.851.26
Long-Term Erngs Book Value Sales Cash Flow Historical Erngs
10.55 3.192.47 2.98 1.17
0.86 0.380.32 0.24 0.09
CashStocks Bonds Other Foreign (% of Stock)
98.91.0 0.0 0.12.8 Total Stocks: 133
Share change since 02-29-16 Sector YTD Ret % % Assets
Facebook Inc A Apple Inc Berkshire Hathaway Inc B Alphabet Inc A Alphabet Inc C General Electric Co Coca-Cola Co Visa Inc Class A The Home Depot Inc Amazon.com Inc JPMorgan Chase & Co Chevron Corp Medtronic PLC MasterCard Inc A Nike Inc B Amgen Inc Chubb Ltd Goldman Sachs Group Inc Salesforce.com Inc American Tower Corp
Technology Technology Finan Svcs Technology Technology Industrl Cnsmr Def Finan Svcs Cnsmr Cyc Cnsmr Cyc Finan Svcs Energy Hlth Care Finan Svcs Cnsmr Cyc Hlth Care Finan Svcs Finan Svcs Technology Comm Svcs
12.34 -10.45 10.18 -9.01
— 93.87
18.83 7.01 13.33 0.51 18.31 21 0.44 11.68 0.54 0.41 41 44,822
45.86 -49.40 -10.96 -12.40 0.13 -49.52 95 0.11 2.86 0.73 0.37 57 18,948
64.32 41.13 3.92 14.67 0.78 40.35 23 0.36 0.02 0.71 0.51 67 22,610
88.47 -1.07 -0.90 -2.81 0.00 -1.07 28 0.00 0.00 —―
—―
—―
12,992 73.27
17.99 2.73 1.99 1.59 16.39 21 1.00 0.02 0.54 0.69 99 11,869
92.37 35.30 1.81 2.91 0.92 34.37 34 0.675.85 0.47 1.27 88 13,542
92.52 14.08 1.03 0.39 0.80 13.27 10 11.430.71 0.50 0.92 77 14,107
89.43 -1.614.06 2.67 0.59 3.4647 0.54 6.44 0.68 0.83 71 13,468 71.67
12.41 -4.30 -2.66 0.84 11.56 76 0.54 0.07 0.75 0.49 39 19,913
62.98 -11.55 -14.19 -13.66 -12.120.57 97 0.41 0.02 0.60 0.83 42 12,985
NAV Total Return % +/- Bmark 1 +/- Bmark 2 Income Return % Capital Return % Total Rtn % Rank Cat Income $ Capital Gains $ Expense Ratio % Income Ratio % Turnover Rate % Net Assets $mil 89.52
-1.867.22 -8.58 0.53 6.6949 0.50 24.66 0.59 0.86 74 44,962
-0.55 -5.100.22 1.76 -2.41 -2.95 14.77 3.390.01 -5.44 -1.87 -8.58— -3.32 8.71
3.69 2.982.58 2.51 2.502.42 2.301.93 1.84 1.791.78 1.54 1.541.47 1.431.41 1.35 1.351.34 1.31 Other Measures Standard Index Best Fit Index
Alpha Beta R-Squared
1.0 1.0694 Rating and Risk
Time Period Load-Adj
Return % Morningstar Rtn vs Cat Morningstar
Risk vs Cat Morningstar Risk-Adj Rating
Market Cap % Giant Large MidSmal Micro Avg $mil:
59,324 47.4 34.4 16.61.4 0.3
Sector
Weightings % of
Stocks Rel
Bmark 1 Cyclical
BasicMat CnsmrCyc FinanSvcs Real Est
34.53 14.211.52 17.34 1.46
1.17 0.480.75 3.38 0.68 Sensitive
CommSrvs Energy Industrl Technlgy Defensive CnsmrDef Hlthcare Utilities
23.35 7.04 16.31 0.00
0.840.63 1.00 0.00 Performance Quartile (within Category)
Figure 4.5 Morningstar report
Source: Morningstar Mutual Funds, © 2016 Morningstar, Inc.
1. Unit investment trusts, closed-end management companies, and open-end management com- panies are all classified and regulated as investment companies. Unit investment trusts are essentially unmanaged in the sense that the portfolio, once established, is fixed. Managed investment companies, in contrast, may change the composition of the portfolio as deemed fit by the portfolio manager. Closed-end funds are traded like other securities; they do not redeem shares for their investors. Open-end funds will redeem shares for net asset value at the request of the investor.
2. Net asset value equals the market value of assets held by a fund minus the liabilities of the fund divided by the shares outstanding.
3. Mutual funds free the individual from many of the administrative burdens of owning individual securities and offer professional management of the portfolio. They also offer advantages that are available only to large-scale investors, such as discounted trading costs. On the other hand, funds are assessed management fees and incur other expenses, which reduce the investor’s rate of return. Funds also eliminate some of the individual’s control over the timing of capital gains realizations.
4. Mutual funds are often categorized by investment policy. Major policy groups include money market funds; equity funds, which are further grouped according to emphasis on income versus growth or specialization by sector; bond funds; international funds; balanced funds; asset alloca- tion funds; and index funds.
5. Costs of investing in mutual funds include front-end loads, which are sales charges; back-end loads, which are redemption fees or, more formally, contingent-deferred sales charges; fund oper- ating expenses; and 12b-1 charges, which are recurring fees used to pay for the expenses of mar- keting the fund to the public.
6. Income earned on mutual fund portfolios is not taxed at the level of the fund. Instead, as long as the fund meets certain requirements for pass-through status, the income is treated as being earned by the investors in the fund.
7. The average rate of return of the average equity mutual fund in the last four decades has been below that of a passive index fund holding a portfolio to replicate a broad-based index like the S&P 500 or Wilshire 5000. Some of the reasons for this disappointing record are the costs incurred by actively managed funds, such as the expense of conducting the research to guide stock-picking activities, and trading costs due to higher portfolio turnover.
The record on the consistency of fund performance is mixed. In some sample periods, the better-performing funds continue to perform well in the following periods; in other sample periods they do not.
SUMMARY
investment company net asset value (NAV) unit investment trust open-end fund
KEY TERMS closed-end fund
loadhedge fund funds of funds
12b-1 fees soft dollars turnover
exchange-traded funds (ETFs)
1. Would you expect a typical open-end fixed-income mutual fund to have higher or lower operating expenses than a fixed-income unit investment trust? Why?
2. What are some comparative advantages of investing in the following?
a. Unit investment trusts.
b. Open-end mutual funds.
c. Individual stocks and bonds that you choose for yourself.
PROBLEM SETS
3. Open-end equity mutual funds find it necessary to keep a significant percentage of total invest- ments, typically around 5% of the portfolio, in very liquid money market assets. Closed-end funds do not have to maintain such a position in “cash equivalent” securities. What difference between open-end and closed-end funds might account for their differing policies?
4. Balanced funds, life-cycle funds, and asset allocation funds all invest in both the stock and bond markets. What are the differences among these types of funds?
5. Why can closed-end funds sell at prices that differ from net asset value while open-end funds do not?
6. What are the advantages and disadvantages of exchange-traded funds versus mutual funds?
7. An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end load of 6%. What is the offering price?
8. If the offering price of an open-end fund is $12.30 per share and the fund is sold with a front- end load of 5%, what is its net asset value?
9. The composition of the Fingroup Fund portfolio is as follows:
Stock Shares Price
A 200,000 $35
B 300,000 40
C 400,000 20
D 600,000 25
The fund has not borrowed any funds, but its accrued management fee with the portfolio manager currently totals $30,000. There are 4 million shares outstanding. What is the net asset value of the fund?
10. Reconsider the Fingroup Fund in the previous problem. If during the year the portfolio manager sells all of the holdings of stock D and replaces it with 200,000 shares of stock E at $50 per share and 200,000 shares of stock F at $25 per share, what is the portfolio turnover rate?
11. The Closed Fund is a closed-end investment company with a portfolio currently worth
$200 million. It has liabilities of $3 million and 5 million shares outstanding.
a. What is the NAV of the fund?
b. If the fund sells for $36 per share, what is its premium or discount as a percent of net asset value?
12. Corporate Fund started the year with a net asset value of $12.50. By year-end, its NAV equaled
$12.10. The fund paid year-end distributions of income and capital gains of $1.50. What was the (pretax) rate of return to an investor in the fund?
13. A closed-end fund starts the year with a net asset value of $12.00. By year-end, NAV equals
$12.10. At the beginning of the year, the fund was selling at a 2% premium to NAV. By the end of the year, the fund is selling at a 7% discount to NAV. The fund paid year-end distributions of income and capital gains of $1.50.
a. What is the rate of return to an investor in the fund during the year?
b. What would have been the rate of return to an investor who held the same securities as the fund manager during the year?
14. a. Impressive Fund had excellent investment performance last year, with portfolio returns that placed it in the top 10% of all funds with the same investment policy. Do you expect it to be a top performer next year? Why or why not?
b. Suppose instead that the fund was among the poorest performers in its comparison group.
Would you be more or less likely to believe its relative performance will persist into the following year? Why?